How Order Book Liquidity Adapts to Predictable Market Order Flow

Summary

The paper examines how limit order book liquidity responds to persistent, predictable order flow. Buy and sell market orders are encoded by direction, and their signs have slowly decaying autocorrelation. Because orders can move prices, this persistence raises a market-efficiency question. The authors discuss asymmetric liquidity: order impact tends to vary inversely with the probability of an order’s occurrence.

Their empirical findings show that higher predictability in one direction is associated with reduced liquidity on the opposite side, while the chance that a trade changes the price falls significantly. The latter effect can counterbalance persistent flow and help maintain efficient, diffusive prices; the former pushes in the opposite direction. A statistical order book model adjusts market order volume to local flow predictability and reproduces diffusive price behavior across time scales, along with several observed order book relationships. The excerpt does not specify the market sample or parameter estimates, limiting assessment of generalizability.

Key ideas

• Order flow signs show slowly decaying autocorrelation, creating a challenge for explaining efficient price behavior.
• Liquidity on the side opposite increasingly predictable order flow tends to decrease.
• The probability of a trade moving the price also decreases significantly as directional predictability rises.
• A model adjusts market order volume to local predictability and reproduces diffusive prices across time scales.
• The excerpt omits market sample details, limiting conclusions about how broadly the findings apply.

Tags

# The adaptive nature of liquidity taking in limit order books


# The adaptive nature of liquidity taking in limit order books









In financial markets, the order flow, defined as the process assuming value one for buy market orders and minus one for sell market orders, displays a very slowly decaying autocorrelation function. Since orders impact prices, reconciling the persistence of the order flow with market efficiency is a subtle issue. A possible solution is provided by asymmetric liquidity, which states that the impact of a buy or sell order is inversely related to the probability of its occurrence. We empirically find that when the order flow predictability increases in one direction, the liquidity in the opposite side decreases, but the probability that a trade moves the price decreases significantly. While the last mechanism is able to counterbalance the persistence of order flow and restore efficiency and diffusivity, the first acts in opposite direction. We introduce a statistical order book model where the persistence of the order flow is mitigated by adjusting the market order volume to the predictability of the order flow. The model reproduces the diffusive behaviour of prices at all time scales without fine-tuning the values of parameters, as well as the behaviour of most order book quantities as a function of the local predictability of order flow.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.